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The Economics of Cigarette Taxation Essay Sample

Introduction

Cases of death due to smoking have been increasing for the past years and this alarming condition already caught the attention of many federal officials and enough for them to make the necessary actions in order to discourage the consumption of cigarettes, one of the socially unacceptable” products in the market. One way by which the government attacks this problem on cigarette smoking would be to tighten their tax policies on cigarettes and other tobacco related products. By putting enough market pressure for prices of cigarettes in the market to increase, the government expects drop on the level of supply and consumption of cigarettes in the market, thereby, resulting on the promotion of secured health on the part of smokers and non-smokers in the society as well as for the government to generate more revenues. At the end of the day, increasing excise tax of cigarettes will provide social welfare improvement.

In order to fully understand the reason behind excise tax provision on cigarettes as well as on how uplifting of cigarette tax rates promotes social welfare improvement, the following cigarette tax increase case of California and New York will be discuss in details alongside with the impacts of higher cigarette tax on the government, non-smokers, smokers, and cigarette retailers/producers.

How Taxation Works

Cigarettes, liquors and other products that are considered to be socially undesirable and addictive are being taxed by the government in order to control its availability in the market. Sin taxes, or taxes being charged to companies producing socially undesirable products, provide welfare distribution equity among the producers and consumers in the market. Taxes charged on cigarettes and other socially undesirable products promotes equity in the distribution of welfare between the consumers and producers through revealing the true and socially optimal price level and production level of a given undesirable product. As for the case of cigarette, the externality emitting agent would be the cigarette producers and the affected party would be the cigarette smokers and those persons that do not smoke. In other words, the tax being imposed by the government to cigarette producers serves as a tool in order to force the latter to manufacture cigarettes at a socially optimal level. Oftentimes, the amount of tax being imposed by the government is equal to the negative externality that cigarette producers impose to the society.

The main reason behind the taxation of cigarettes in the market is fact that it harms the health conditions of its users as well as those persons who will unwantedly inhale cigarette smokes. Cigarette smokes are considered to be providing negative externalities to the non-smokers and causes health ailments to cigarette smokers. Based from the idea behind externalities, it is a must for the government to impose tax, or other forms of intervention, on negative externality emitting agents in order to attain socially optimal level of supply of a given product, and so with its price and demand. The negative externalities imposed by cigarette producers to both smokers and non-smokers must be included on their production costs in order for them to only produce cigarettes at a socially acceptable level. Without the presence of cigarette tax, cigarette producers will always produce cigarettes in the market greater than what is socially allowable. In other words, tax on cigarettes represents the negative externalities emitted by cigarette producers in the market in monetary terms.

The value of negative externalities imposed by cigarette producers can be converted into monetary terms through determining the willingness to pay of those non-smokers in exchange for not inhaling cigarette smokes or the cost of ailment of those smokers, which must be added on the production cost of cigarette producers for them to only produce cigarettes at a socially optimal level [where both producers and consumers are well off]. Remember that private cost is always lower than social cost since the former do not include all the indirect costs/effects of their production activity on the environment and on the society. Through cigarette taxes, e.g. sin tax, the government will put enough pressure for the cigarette producers to cut their production, thereby resulting to smaller supply of cigarettes in the market. Given a limited supply of cigarettes in the market as a result of imposing tax on cigarettes, the volume of cigarette smokes in the environment is expected to decrease leading to welfare improvement on the part of those non-smokers and smokers [in terms of health value]. In addition to this, the government gets additional revenue from the provision of cigarette tax which can be useful in financing government projects and programs.

Though the government successfully promoted welfare improvement [health improvement], one side effect of sin tax would be the rise of cigarette prices in the market due to the limited supply of it in the market. At the end of the day, cigarette smokers will carry all the burden of cigarette taxes. On the other hand, this rising of cigarette prices would provide enough room for the government to discourage the purchase of cigarette in the market. Yet again, this discouragement of the government will only be useless since cigarette smokers will still buy cigarettes considering that it is one of the most addictive products in the market. In other words, it is only the non-smokers and the government are the only party that will gain from the provision of cigarette tax in the market, while cigarette smokers will experience welfare losses due to high prices of cigarettes.

Cigarette Tax in California

California is one of the many cities housing large number of cigarette smokers in the market. In addition to this, cigarette manufacturers find California to be one of the most profitable markets due to the large population of cigarette smoker in the said state. In order for the California state government to discourage smoking, various tax policies were already been implemented. Recently, a motion was already raised aiming to increase the tax being levied on tobacco to 300% in order to “stamp out” smoking by making it costly. Moreover, the said tax proposal, identified as Proposition 86, would possibly raise cigarette tax from $0.87 to $3.47, same goes for cigars and other tobacco products (Welch, 2006).

Through attacking tobacco, the main input in making cigarettes, the California government officials envisions a sudden drop on the consumption of cigarettes within the vicinity of California, especially in Los Angeles where most number of cigarette smokers can be found. Once the price of tobacco increased due to the said new tax scheme, production cost of manufacturing cigarettes in the market will also increase leaving cigarette manufacturers with fewer profits available. One way to protect their interests, cigarette manufacturers opt to increase the prices of their cigarettes in the market in order to recover from the additional production costs imposed by the said new tax scheme on tobacco. The key in this new tax scheme would be for the cigarette manufacturers to pass the additional production costs caused by higher tobacco tax to the cigarette smokers in the market.

In case the said new tax scheme will be enacted, it will go to be the highest levy on cigarettes relative to other states of the country, which only reflects the effort of the government to discourage the consumption of cigarettes, and at the same time to generate higher revenues. On the other hand, the provision of this new tax scheme could cause various problems such as smuggling, gang activity, and the shattering of small retailers in the market (Chamberlain, 2006).

Essentially, there are two types of excise taxes currently being implemented in California namely [1] the cigarette tax and [2] the cigarette and tobacco products surtax (California State Board of Equalization, 2008). All cigarettes, cigars, and other tobacco related products are subjected to the above mentioned tax schemes of the Californian government. The way by which distributors pays tax and surtax in California is through the use of tax stamps which are purchased from the Board of Equalization. This tax stamps are included to each package of cigarettes before distribution to the market, while each tax stamp already includes both the cigarette tax and surtax. At present, the price of each tax stamp is amounting to $0.87 per pack of 24 cigarettes. In addition to this, in terms of percentage composition, around 14% of the price of tax stamps originates from cigarette tax which is equivalent to $0.12; whereas, surtax accounts to the remaining 86% of the tax stamps equivalent to $0.75. In other words, surtax contributes largely on the price level of tax stamps.

Moreover, it is only the tobacco products, excluding cigarettes, such as cigars, smoking tobacco, chewing tobacco, snuff and tobacco products containing at least 50% tobacco are subject to cigarette and tobacco products surtax. The surtax rate, on the other hand, is set annually by the State Board of Equalization and is equivalent to the combined rate of tax applied to cigarettes. In addition to this, in order for the State Board of Equalization to monitor and control the volume of cigarettes and other tobacco products in the market, they require to register the distributors and wholesalers of cigarettes or tobacco products in the market.

Actually, it is not only those cigarettes and other tobacco products produced/purchased in California that are affected by excise tax, even cigarettes purchased outside California is taxed once it enter the vicinity of the latter. As for the case of cigarettes and tobacco products purchased outside and shipped to California, either through the mail, telephone, or internet, the consumer is still required to pay the California excise tax directly to the State Board of Equalization. Moreover, consumers also have to pay the California excise tax specifically when they physically bring tobacco or more than 400 cigarettes into California.

Based from the effects of previous and current tax schemes to cigarettes and other tobacco products, demand for cigarettes and other tobacco products slightly decreased while its price level increased significantly as cigarettes and tobacco-related products raise their market prices to offset losses that they incur from higher excise tax. By the time the consumption of cigarettes and other tobacco products in the market decreased, negative externalities in California, in the form of health threats on smokers and non-smokers, will be minimized (BNET Business Network, 2006). Furthermore, with the imposition of higher tax rate on cigarettes and other tobacco products, cigarette manufacturers start to produce socially accepted volume of cigarettes and other tobacco products in the market, thereby fulfilling the objective of the government – equity in the distribution of welfare between consumers and producers.

Aside from the idea that the California government would want to discourage the consumption of cigarettes and other tobacco products in the market, it was also found out, based from the data collected from other states, that cigarette and other tobacco products taxation is a good way to generate large amounts of income. Between 2007 and the first quarter of 2008, the state and local governments, including California, experienced around $2 billion increase in the excise tax revenue after increasing the level of tax rate imposed in the recent years. The revenue that will be generated by the Californian government from the provision of 300% increase on tobacco tax, if ever passed, will be allotted to support their new or expanded programs for health services, children’s health coverage, and tobacco related activities.

Cigarette Tax in New York

In essence, it is the New York City Department of Finance and the New York State Department of Taxation and Finance are the main agencies that enforce cigarette taxes in New York are the ones in-charge of regulating the sale of cigarettes within New York State and New York City. To be more specific, it is the role of the New York State Department of Taxation and Finance to launch campaigns against those cigarette sellers/producers who try to evade the cigarette tax (New York City Department of Finance, 2008). It is also the role of the New York State Department of Taxation and Finance to educate the public as well as to collect tax on untaxed cigarettes and provide legal action to those people who will engage in cigarette tax fraud. Like on the case of California, New York state officials also imposes cigarette tax even to cigarettes and other tobacco related products originated outside New York. The purchase of cigarettes through the internet and direct mail is also covered by the cigarette tax scheme of New York. In 2007, cigarette tax in New York generated more than $3 billion revenue for the state of New York. This only suggests that one of the purposes of cigarette tax provisions in the state of New York would be for the government to generate more income.

Though the state of New York generates large amounts of revenues from taxing cigarette products in their market, the primary objective of the New York state officials for providing such tax policy is to discourage the consumption of cigarette in New York especially to minor-age smokers. Back in 2003, Mayor Michael Bloomberg raised the cigarette excise tax in New York from $0.8 to $1.5 in order to cut the consumption of cigarette smokers in the said state. Through forcing the prices of cigarettes in the market to rise, the state officials of New York expected sudden downturn on the quantity demanded of cigarettes in their market, especially on the part of minor-age smokers since the said consumer segment is relatively price sensitive compared to other consumer segment of cigarettes. In other words, the provision of cigarette tax in New York targets the youth sector since the latter is much sensitive to price changes compared to adult cigarette smokers.

On the other hand, on the part of cigarette retailers and producers, they experienced significant fall on their profitability as the demand of youth for cigarette declined dramatically as a consequence of higher prices of cigarettes in the market. Remember that cigarette producers and retailers pass into their customers the cigarette and other tobacco products tax through price increase. In other states where majority of smokers are adults, price increase in cigarettes only made small impact on the total demand for cigarettes in the market. But for the case of New York, where most cigarette smokers are youth with limited income on their pockets, price increase in cigarettes, as a by-product of passing of cigarette tax from producers/retailers to consumers, puts enough pressure for the demand of cigarettes in the market to decrease dramatically.

At present, the New York State officials already passed a new cigarette tax scheme which robustly increases the previous tax rate from $2.75 per cigarette pack to $4.25 (Martin, 2008). But the said new tax scheme is only being applied in New York City, $1.5 per cigarette pack, considering that the bulk of cigarette smokers in the state of New York are located in New York City (Federation of Tax Administrators, 2008). In other words, the said new tax rate on cigarettes in New York is a combination of state and local tax rate [$2.75 state + $1.5 New York City]. Those people in the state of New York not residing in New York City are still enjoying a relatively cheaper cigarettes compared to cigarettes being sell in New York City due to the additional $1.5 cigarette excise tax of New City local government. As a result, the state of New York is now housing the highest cigarette excise tax in the nation and the government is expected to generate revenue in the said new tax scheme equal to around $265 million per year (Fox News, 2008).

Furthermore, the $4.25 cigarette tax in New York City is projected by the New York State officials to increase the total revenue of the government on cigarette tax to a total of $1.3 billion until 2009. Considering that youth smokers are sensitive to price changes, the said new cigarette tax rate in New York City would cut down the demand of youth on cigarettes. It is being expected by the local officials of New York City that around 250,000 youth will be prevented from smoking through the provision of such new cigarette tax scheme. On the part of adult consumers, around 140,000 adult consumers are expected to quit smoking given such expensive price of cigarettes in New York City’s market (Philippine Daily Inquirer, 2008).

On the other hand, the main objective of the local officials of New York City for providing such increase in cigarette excise tax would be for them to make people stop from smoking and not to pay its high price. Increasing the prices of cigarettes in New York City’s markets would provide enough pressure for smokers to think twice in buying cigarettes considering its sky rocketing price. Income generation from increasing the excise tax on cigarette would be just a secondary objective of the local officials of New York City.

In theory, tax hike on socially undesirable goods would be ineffective, especially if the objective of the government is to discourage the consumption of such socially undesirable product since consumers will still keep on buying them because they are addictive. Price changes on socially unaccepted products will only impose small influence on the demand of consumers. But for the case of New York, since the youth is the target consumer segment of the government and are price sensitive, even if cigarettes are addictive in nature, the provision of higher tax on cigarette became effective in cutting the number of smokers in the market. Both non-smokers and the government are the only party that will gain welfare improvement from such provision of higher cigarette tax in New York City.

The only problem now, is for the local officials of New York City to prevent the rise of “black market” for cigarettes considering the high demand for cheaper cigarettes in New York City. The bootleg and smuggled cigarettes are relatively cheaper since they do not have taxes on their prices compared to the commercially available cigarettes in the market (Fleenor, 2003). Smokers in New York City, same goes to other states, finds cigarettes in the black market as a perfect alternative on commercially available cigarettes in New York City’s market. In the long run, if this problem on the rising industry of cigarette black market, this might affect the success of providing tax in cigarettes as well as threatens the profitability of cigarette retailers since demand for commercial cigarettes will further decline as smokers, especially the youth, shifts their consumption to black market cigarettes. Therefore, the New York State Department of Taxation and Finance must intensify its campaign against cigarette smugglers and other people participating in the underground economy of cigarettes amidst the rising prices of cigarettes in New York City due to higher cigarette tax.

Consequences

One major consequences of providing higher excise tax on cigarettes would be the welfare deterioration of cigarette smokers in California and New York, and so with other states. The said welfare deterioration of smokers is the result of paying higher for a given unit of cigarette given a limited budget. Smokers, especially the minor aged smokers, are price sensitive as noted a while ago. Any increase on the prices of cigarette in the market would deliberately cut the amount of utilities that minor-age smokers derive from consuming cigarettes, thus having a lower welfare.

On the part of the cigarette retailers, the provision of higher cigarette tax in the market would certainly pose higher market uncertainty considering the potential downturn on the demand of smokers for cigarette in the market or the shifting of smokers from consuming commercially available cigarettes to black market cigarettes. At the end of the day, retailers will suffer from lower profitability due to relatively lower demand of smokers on cigarettes. It would take some time before these retailers will be able to recover from such profit loss. In this regard, smokers and cigarette retailers/producers are the parties that will be negatively affected by the government’s move on increasing the excise tax on cigarettes.

On the other hand, as for the side of the non-smokers, the cut on the consumption/number of smokers in the society lessens health threats on their part considering that second hand smokes are relatively harmful than first hand smokes. In addition to this, the negative externalities that smokers impose on non-smokers are also minimized as the number of smokes emitted in the environment decreases as a consequence of lower cigarette consumption/fewer smokers. In other words, non-smokers in the society benefits in the provision of higher excise tax on cigarettes.

Like the non-smokers, the government also benefits in increasing the tax rate impose on cigarettes since it would cause them to generate more income and at the same time fulfilling their role for equally distributing welfare from the side of the producers to the consumers. In addition to this, the government also was able to promote socially accepted level of production of cigarettes in the market, assuming that the tax rate imposed by the government is equal to the average negative externalities imposed by cigarette retailers/cigarette producers in monetary terms.

In terms of Cost and Benefit Analysis of increasing the excise tax for cigarettes in the country, given the case of California and New York and the affected parties, it is therefore clear that such policy provision is beneficial to the society as a whole since it promotes health security on the part of both smokers and non-smokers and provide the government with higher revenues. In addition to this, the society in general attains Pareto Improvement Condition since the gains of the non-smokers and the government offsets the losses of smokers and cigarette retailers/producers

The effects of increasing the excise tax of cigarettes in the market are summarized by the given relationships below.

Tax Production cost/retail cost Supply Price Demand

As shown in the illustration above, the case of cigarette taxation is basically explained by the theory of supply and demand. Given that tax is one of the inputs in producing cigarettes in the market, any increase on the tax rate will tend to increase the production cost of manufacturing cigarettes. And in order for the cigarette producers to protect their interests, what they tend to do is to pass the cigarette tax that they received from the government through raising the prices of their cigarettes in the market and cut their volume of production given the limited capital that they have. With the combined forces of higher production costs and low supply of cigarettes in the market, while the demand for cigarette is high, price of cigarette in the market will surely increase.

Though the demand of cigarettes in New York City decrease, but the effect of shortage of supply of cigarette in the market is greater than the depletion of smoker’s demand for cigarette, this is the reason why at the end of the day, prices of cigarettes in New York City still increases dramatically. Given that disposable income of most households nowadays is depleting as a consequence of low wage rate, there is a tendency that adult smokers will also become price sensitive just like minor-age smokers. As a result of this, an increase in the tax rate of cigarettes in various states would cause a sudden drop on the consumption of adult smokers on cigarettes. But the end effect of higher cigarette tax provision would remain the same – higher government revenue, welfare improvement of non-smokers, and welfare loss on smokers and cigarette retailers/producers.

Conclusion

Based from the case of California and New York, increasing excise tax of cigarette would be one of the best ways in order for the government to promote social welfare improvement. Like in California and New York, non-smokers can now enjoy lesser smokes in the atmosphere which can threaten their health condition once they inhale it. Furthermore, the government receives higher revenues from providing such kind of policy which can be allotted to other productive projects like health services and/or expanding/providing children’s health coverage. At the end of the day, in economics, it is the overall welfare improvement that is important, which makes cigarette tax economically beneficial to the country.

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